In the same month that Babcock & Brown completed its financing for the Trans-Bay Cable (page opposite), American Electric Power and MidAmerican Energy unveiled a radically different take on financing transmission upgrades. The $250 million financing for Electric Transmission Texas LLC (ETT), a joint venture between the two, demonstrates that large and well-capitalised utilities hold many advantages in developing transmission assets, even when deregulation encourages the formation of independent operators.

ETT's exclusive area of operations is inside the Electrical Reliability Council of Texas (ERCOT), the grid operator for an area roughly, but not exactly encompassing the state. Texas, in electricity as in its attitude towards its roads programme, guards its independence jealously. ERCOT is not under the regulation of the Federal Energy Regulatory Commission, and generators and transmission providers may not structure their business in such a way that would expose Texas-based power assets to FERC's regulation.

Texas has gone much further towards deregulation than any other state in the US. Parts of the northeast, and in particular, New York State, offer similar levels of competition in electricity supply, but Texas has an advanced and liquid wholesale power market and has encouraged an unbundling of generation, transmission and distribution.

Companies that hive off their transmission assets enjoy several benefits, including favourable cost recovery treatment, and accelerated depreciation for tax purposes. The tax benefits are the same wherever a transmission line is located, while the cost recovery mechanisms vary in their details inside and outside Texas but are reasonably similar in creating a strong credit profile.

AEP Texas has 900,000 customers across the south and west of the state, grouped under AEP Texas North and AEP Texas Central, Mid-American's electrical utility operations are concentrated in Iowa, although its gas operations are active in Texas. But ETT's purpose is less to acquire the existing assets of the two utility owners, than to finance new additions on a competitive basis.

The joint venture dates to November 2006, when AEP promised to contribute $100 million in assets under development to the new venture, and MidAmerican sufficient cash equity to give it a 50% stake. The vehicle has a target debt-to-equity ratio of 60/40, in line with ERCOT's expectations. Babcock & Brown's Trans-Bay Cable has a near 50/50 debt equity split, reflecting FERC's expectations as to the financial structure of a transmission project.

ETT is structured so that AEP will construct the transmission assets on its own balance sheet and then sell these to ETT at completion. The arrangement avoids exposing ETT, which enjoys a low cost of capital as a result of its regulated status, to construction risk. MidAmerican's interest in the venture is primarily financial, and its participation allows ETT to obtain separate treatment for financial and regulatory purposes.

But AEP is providing the expertise, and has a much longer history developing such assets than the independent players. It will be staffing the new entity from its own resources and benefiting from distributions from the joint venture, although it will be bankruptcy-remote.

The first assets to be contributed are likely to be a number of transformers located near the city of Laredo, close to the border of Texas with Mexico. The assets are small, discrete, and essential to grid operation and stability, especially since they are close to the interties that AEP operates with the Comision Federal de Electricidad, Mexico's state electricity company. The assets include a variable frequency transformer, that will allow power to flow more easily between the two.

ETT has raised a $250 million revolving credit from Citigroup and Royal Bank of Scotland to serve as an acquisition facility, to be drawn upon as and when the joint venture wants to buy a transmission asset from AEP. In this respect it resembles the revolving credits that master limited partnerships (MLP) keep on hand so as to move quickly on the acquisition of midstream oil and gas assets.

In this instance, the borrower has an even better credit profile than an MLP, and this allowed ETT to price its five-year debt at around 60bp over Libor, just a shade over the 45bp that AEP paid in March for its most recent $1.5 billion corporate loan. Eight banks participated in the ETT revolving credit, which is non-recourse to both sponsors.

This pricing reflects the speed with which the transmission vehicle can gain approval to include the cost of the transmission project in what it charges to the utilities that use the Texas grid. Under expedited approval processes, AEP can contribute assets to the venture, and the venture can file to recover costs, within a 60-day timeframe. For larger and more complex projects that might have a different cost structure, the venture can still go through a longer and more drawn-out process.

The two sponsors have said that at least $1 billion in transmission assets could be contributed to the venture in the next several years, and have announced plans for a backbone transmission project for renewable energy generators that would be much larger. Wind generation, which tends to be located some distance from where demand is located, calls for a substantial investment in new transmission facilities.

However, some of these assets would not be located within the ERCOT footprint, and gaining approvals will be a complex process. Moreover, other utilities are already looking to develop similar projects, including the Panhandle Loop proposal from Babcock & Brown, Airtricity and Sharyland, and a DC tie running from the Panhandle to the Dallas area, which FPL is proposing.

But the venture is unlikely to seek outside equity from infrastructure funds, despite their healthy levels of funding and hunger for assets. Utilities are well-capitalised, and have been building such projects for years. Given their ability to warehouse construction risk cheaply, their ability to dominate transmission markets even after deregulation is formidable.

Electric Transmission Texas LLC
Status: Closed 28 September 2007
Size: $250 million
Location: Texas
Description: Acquisition facility for spun-off transmission subsidiary
Sponsors: AEP and MidAmerican Energy
Debt: $250 million
Arrangers: Citigroup and Royal Bank of Scotland
Independent engineer: Sargent & Lundy
Lender legal adviser: King & Spalding
Sponsor legal adviser: Clark Ashworth & Milby